In Short: Fundamentals favor shorter duration

11-02-2017

Strengthening U.S. growth, leading signs of a potential pickup in inflation via higher wages & rising commodity prices, and a Fed that appears committed to a rate hike in December prompted Federated’s fixed-income duration committee to shift moderately shorter on duration. The aforementioned, combined with expectations of eventual fiscal stimulus from tax cuts and the likely maintenance of overall policy normalization no matter who heads the Fed should support an upward bias in Treasury yields as we move into year-end.

That said, there are reasons to believe any move up in yields will be constrained. For one, tax cuts are unlikely to become reality this year. The legislative clock is running out and the horse-trading has yet to start amid polls that show the public is not all that enamored with some of the rumored potential tax changes. That’s not to say tax reform won’t happen—the shared political interests among fractious Republicans to get something done before the November midterm elections is highly motivating. It just seems unlikely that all the i’s can be dotted and t’s can be crossed before year-end on something as complicated as changing the tax code, making Q1 2018 the more likely timing for a deal.

Moreover, Mario Draghi and the European Central Bank are managing to taper in a dovish, gingerly manner, leaving support in place for low yields in the eurozone and related restraint on U.S. yields. Finally, Treasury yields have already moved quite a bit higher compared to late summer. So as long as inflation is building but well below 2%, the yield upside from here likely is a drift upwards, not a spike. Lastly, the Mueller investigation continues and could present challenges to governing and fiscal expansion—another potential drag on yields if a risk-off trade ensues.

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

Duration is a measure of a security's price sensitivity to changes in interest rates. Securities with longer durations are more sensitive to changes in interest rates than securities of shorter durations.